Ebook Macroeconomics (6th edition): Part 1

(BQ) Part 1 book Macroeconomics hass contents: Introduction to macroeconomics, the measurement and structure of the national economy; productivity, output, and employment; consumption, saving, and investment; saving and investment in the open economy; the asset market, money, and prices,...and other contents.

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Library of Congress Cataloging-in-Publication Data

Abel, Andrew B.,

1952-Macroeconomics / Andrew B Abel, Ben S Bernanke, Dean Croushore -6th ed

p em - (Addison-Wesley series in economics) Includes bibliographical references and indexes

ISBN 0-321-41554-X

1 Macroeconomics 2 United States-Economic conditions 1 Bernanke, Ben

II Dean Crollshore III Title

HBl72.5.A24 2008

339-dc22

Copyright © 2008 Pearson Education, Inc

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ISBN 13: 978-0-321-41554-7

ISBN 10: 0-321-41554-X

1 2 3 4 5 6 7 8 9 10-DOW-1O 09 08 07 06

Andrew B AbeL

The Wharton School of the University of Pennsylvania

Ronald A Rosen­

feld Professor of Finance a t The Wharton School and professor of economics at the Uni­

versity of Pennsylvania, Andrew Abel

received his A.B summa cum laude from

Princeton University and his Ph.D

from the Massachusetts Institute of

Technology

He began his teaching career a t the

University of Chicago and Harvard Uni­

versity, and has held visiting appoint­

ments at both Tel Aviv University and

The Hebrew University of Jerusalem

A prolific researcher, Abel has pub­

lished extensively on fiscal policy, cap­

ital formation, monetary policy, asset

pricing, and Social Security-as well as

serving on the editorial boards of

numerous journals He has been hon­

ored as an Alfred P Sloan Fellow, a

Fellow of the Econometric Socie ty,

and a recipient of the John Kenneth

Galbraith Award for teaching excel­

lence Abel has served as a visiting

scholar at the Federal Reserve Bank of

Philadelphia, as a member of the Panel

of Economic Advisers at the Congres­

sional Budget Office, and as a member

of the Technical Ad visory Panel on

Assumptions and Methods for the

Social Security Advisory Board He is

also a Research Associa te of the

National Bureau of Economic Research

and a member of the Advisory Board

of the Carnegie-Rochester Conference

fessor of Economics and Public Affairs at Princeton University, Ben Bernanke received his B.A in economics from Har­

vard University sUlI1ma cllm laude-cap­

turing both the Allyn Young Prize for best Harvard undergraduate economics thesis and the John H Williams prize for outstanding senior in the economics department Like coauthor Abel, he holds a PhD from the Massachusetts Institute of Technology

Bernanke began his career a t the Stanford Graduate School of Business

in 1979 In 1985 he moved to Princeton University, where he served as chair of the Economics Department from 1995

to 2002 He has twice been visiting pro­

fessor at M.I.T and once at New York University, and has taught in under­

graduate, M.B.A., M.P.A., and Ph.D

programs He has authored more than

60 publications in macroeconomics, macroeconomic history, and finance

Bernanke has served as a visiting scholar and advisor to the Federal Reserve System He is a Guggenheim Fellow and a Fellow of the Econometric Society He has also been variously hon­

ored as an Alfred P Sloan Research Fellow, a Hoover Institution National Fellow, a National Science Foundation Graduate Fellow, and a Research Asso­

ciate of the National Bureau of Economic Research He has served as editor of the American Economic Review In 2005 he became Chairman of the President's Council of Economic Advisors He is currently Chairman and a member of the Board of Governors of the Federal Reserve System

Dean Croushore

Robins School of Business, University

of Richmond

Dean Croushore is associate professor

of economics and Rigsby Fellow at

the University of Richmond He received his A.B from Ohio University and his PhD from Ohio State University Croushore began his career at Penn­ sylvania State University in 1984 After teaching for five years, he moved to the Federal Reserve Bank of Philadel­ phia, where he was vice president and economist His duties during his four­ teen years a t the Philadelphia Fed included heading the macroeconomics section, briefing the bank's president and board of directors on the state of the economy and advising them about for­ mulating monetary policy, writing arti­ cles about the economy, administering two national surveys of forecasters, and researching current issues in monetary policy In his role a t the Fed, he crea ted the Survey of Professional Forecasters (taking over the defunct ASAjNBER survey and revitalizing it) and devel­ oped the Real-Time Data Set for Macro­ economists

Croushore returned to academia at the University of Richmond in 2003 The focus of his research in recent years has been on forecasting and on how data revisions affect monetary policy, forecasting, and macroeconomic research Croushore's publications include articles in many leading eco­ nomics journals and a textbook on money and banking He is associate editor of several journals and visiting scholar at the Federal Reserve Bank of Philadelphia

v

2 The Measurement and Structure of the National Economy 23

3 Productivity, Output, and Employment 62

4 Consumption, Saving, and Investment 110

5 Saving and Investment in the Open Economy 173

6 Long-Run Economic Growth 212

7 The Asset Market, Money, and Prices 247

8 Business Cycles 282

9 The IS-LM/AO-AS Model: A General Framework

for Macroeconomic Analysis 310

10 Classical Business Cycle Analysis: Market-Clearing Macroeconomics 360

11 Keynesianism: The Macroeconomics of Wage and Price Rigidity 398

and Institutions 443

12 Unemployment and Inflation 444

13 Exchange Rates, Business Cycles, and Macroeconomic Policy

in the Open Economy 476

14 Monetary Policy and the Federal Reserve System 529

15 Government Spending and Its Financing 573

Appendix A : Some Useful Analytical Tools 610 Glossarv 617

Name Index 629 Subject Index 631

1.1 What Macroeconomics Is About 2

Long-Run Economic Growth 3 Business Cycles 4

Unemployment 5

Inflation 6

on en s

2.2 Gross Domestic Product 27

The Product Approach to Measuring GOP 27

BOX 2.1 Natural Resources, the Environment, and the National Income Accounts 30

The Expenditure Approach to Measuring GOP 31 The Income Approach to Measuring GOP 34

2.3 Saving and Wealth 37

Measures of Aggregate Saving 37

The Uses of Private Saving 39 Relating Saving and Wealth 40

APPLICATION Wealth Versus Saving 42

The International Economy 8 2.4 Real GOP, Price Indexes, and Inflation 46

Real GOP 46

Macroeconomic Policy 9 Aggrega tion 10

1.2 What Macroeconomists Do 11

Macroeconomic Forecasting 11 Macroeconomic Analysis 12

Macroeconomic Research 13

BOX 1.1 Developing and Testing

an Economic Theory 1 4

Data Development 14

1.3 Why Macroeconomists Disagree 15

Classicals Versus Keynesians 16

A Unified Approach to Macroeconomics 18

CHAPTER 2

The M easurement and Structure

of the National Economy 23

2.1 National Income Accounting:

The Measurement of Production, Income, and Expenditure 23

In Touch with the Macroeconomy:

The National Income and Product Accounts 25

Why the Three Approaches Are Equivalent 26

Real Versus Nominal Interest Rates 53

PART 2 Long - Run Economic

Performance 61

CHAPTER 3

Productivity Output and Employment 62

3.1 How Much Does the Economy Produce?

The Production Function 63

APPLICATION The Production Function of the U.S

Economy and U.S Productivity Growth 64

The Shape of the Production Function 66 Supply Shocks 71

• •

VII

viii Detailed Contents

3.2 The Demand for Labor 72

The Marginal Product of Labor and Labor Demand: An Example 73

A Change in the Wage 75

The Marginal Product of Labor and the Labor Demand Curve 75

Factors That Shift the Labor Demand Curve 77

Aggregate Labor Demand 79

3.3 The Supply of Labor 79

The Income-Leisure Trade-off 80 Real Wages and Labor Supply 80 The Labor Supply Curve 83

Aggregate Labor Supply 84

APPLICATION Comparing U.S and European Labor Markets 85

3.4 Labor Market Equilibrium 87

Full-Employment Output 89

the Real Wage During Oil Price Shocks 90

APPLICATION Technical Change and Wage Inequality 91

3.5 Unemployment 93

Measuring Unemployment 94

In Touch with the Macroeconomy:

Labor Market Data 95

Changes in Employment Status 95

How Long Are People Unemployed? 96 Why There Always Are Unemployed People 97

3.6 Relating Output and Unemployment:

Appendix 3.A The Growth Rate Form

CHAPTER 4

Consumption Saving and Investment 110

4.1 Consumption and Saving 111

The Consumption and Saving Decision of an Individual 112

Effect of Changes in Current Income 114

Effect of Changes in Expected Future Income 114

APPLICATION Consumer Sentiment

and Forecasts of Consumer Spending 1 1 5 Effect of Changes in Wealth 118

Effect of Changes in the Real Interest Rate 119 Fiscal Policy 121

In Touch with the Macroeconomy:

4.3 Goods Market Equilibrium 139

The Saving-Investment Diagram 140

APPLICATION Macroeconomic Consequences of the Boom and Bust in Stock Prices 144

Appendix 4.A A Formal Model

CHAPTER 5

Saving and Investment in

5.1 Balance of Payments Accounting 174

The Current Account 174

In Touch with the Macr o ec o n o m y : The Balance of Payments Accounts 176

The Capital and Financial Account 177

The Relationship Between the Current Account and the Capital and Financial Account 179

BOX 5.1 Does Mars Have a Current

5.2 Goods Market Equilibrium

in an Open Economy 184

5.3 Saving and Investment in a

The Effects of Economic Shocks in

a Small Open Economy 189

5.4 Saving and Investment in

Large Open Economies 191

APPLICATION The Impact of Globalization

on the U.S Economy 193

APPLICATION Recent Trends in the U.S

Current Account Deficit 196

5.5 Fiscal Policy and the

Current Account 199 The Critical Factor: The Response

of National Saving 200 The Government Budget Deficit

and National Saving 201

APPLICATION The Twin Deficits 202

CHAPTER 6

Long - Run Economic G rowth 212

6.1 The Sources of Economic Growth 213

Growth Accounting 215

APPLICATION The Post-1973 Slowdown

in Productivity Growth 217 APPLICATION The Recent Surge in U.S

Productivity Growth 220

6.2 Growth Dynamics:

The Solow Model 223

Setup of the Solow Model 224

The Fundamental Determinants of Long-Run Living Standards 231 APPLICATION The Growth of China 236

Endogenous Growth Theory 238

6.3 Government Policies to Raise

Long-Run Living Standards 240 Policies to Affect the Saving Rate 240

Policies to Raise the Rate of Productivity Growth 241

Measuring Money: The Monetary Aggregates 250

In Touch with the Macroeconomy:

The Monetary Aggregates 251

The Money Supply 251

BOX 7.2 Where Have All the Dollars Gone? 252

7.2 Portfolio Allocation and

the Demand for Assets 253

Expected Return 254

Risk 254

Liquidity 254

Time to Maturity 255 Asset Demands 256 7.3 The Demand for Money 256

The Price Level 257 Real Income 257

Interest Rates 258 The Money Demand Function 259

Other Factors Affecting Money Demand 260 Elasticities of Money Demand 261

Velocity and the Quantity Theory of Money 262

APPLICATION Financial Regulation, Innovation, and the Instability of Money Demand 264

7.4 Asset Market Equilibrium 266

Asset Market Equilibrium: An Aggregation Assumption 266

The Asset Market Equilibrium Condition 268

7,5 Money Growth and Inflation 269

APPLICATION Money Growth and Inflation

in European Countries in Transition 270

The Expected Inflation Rate and the Nominal Interest Rate 272

APPLICATION Measuring Inflation Expectations 273

8.1 What Is a Business Cycle? 283

8.2 The American Business Cycle:

The Pre-World War I Period 285

The Great Depression and World War II 285 Post-World War II U.s Business Cycles 287 The "Long Boom" 288

Have American Business Cycles Become Less Severe? 288

8.3 Business Cycle Facts 290

The Cyclical Behavior of Economic Variables: Direction and Timing 290

Interna tiona I Aspects of the Business Cycle 300

8.4 Business Cycle Analysis: A Preview 301

BOX 8.1 The Seasonal Cycle and the Business Cycle 301

Aggregate Demand and Aggregate Supply:

A Brief Introduction 302

CHAPTER 9

The IS-LM/AO-AS Model : A General Framework for Macroeconomic Analysis 310

9.1 The FE Line: Equilibrium

in the Labor Market 311

Factors That Shift the FE Line 312

9.2 The IS Curve: Equilibrium

in the Goods Market 313

Factors That Shift the IS Curve 315

9.3 The LM Curve: Asset

Factors That Shift the LM Curve 321

9.4 General Equilibrium in the

Complete IS-LM Model 325 Applying the IS-LM Framework: A Temporary Adverse Supply Shock 326

APPLICATION Oil Price Shocks Revisited 328

BOX 9.1 Econometric Models and Macroeconomic Forecasts for Monetary Policy Analysis 329

9.5 Price Adjustment and the Attainment

of General Equilibrium 330

The Effects of a Monetary Expansion 330

Classical Versus Keynesian Versions of

the IS-LM Model 334

9.6 Aggregate Demand and Aggregate Supply 336

The Aggregate Demand Curve 336

The Aggregate Supply Curve 338

Equilibrium in the AD-AS Model 341

Monetary Neutrality in the AD-AS Model 341

Appendix 9.A Worked-Out Numerical Exercise for Solving the IS-LMIAD-AS Model 351

Appendix 9.B Algebraic Versions of the IS-LM

and AD-AS Models 353

CHAPTER 10

Classical Business Cycle Analysis :

Market-Clearing Macroeconomics 360

10.1 Business Cycles in the Classical Model 361

The Real Business Cycle Theory 361

APPLICATION Calibrating the Business Cycle 364

Fiscal Policy Shocks in the Classical Model 371 Unemployment in the Classical Model 375

Household Prod uction 377

10.2 Money in the Classical Model 378

Monetary Policy and the Economy 378

Monetary Nonneutrality and Reverse Causation 378 The Nonneutrality of Money: Additional

Evidence 379

10.3 The Misperceptions Theory and

the Nonneutrality of Money 380

Monetary Policy and the Misperceptions Theory 383

Rational Expectations and the Role

of Monetary Policy 385

BOX 10.1 Are Price Forecasts Rational? 3B7

Appendix 10.A Worked-Out Numerical

Exercise for Solving the Classical AD-AS

Model with Misperceptions 395

Appendix 10.B An Algebraic Version

of the Classical AD-AS Model with

Misperceptions 396

CHAPTER 11

11.1 Real-Wage Rigidity 399

Some Reasons for Real-Wage Rigidity 399 The Efficiency Wage Model 400

Wage Determina tion in the

Efficiency Wage Model 401 Employment and Unemployment in the Efficiency Wage Model 402

Efficiency Wages and the FE Line 404

BOX 11.1 Henry Ford's Efficiency Wage 405

11.3 Monetary and Fiscal Policy in

the Keynesian Model 412

Monetary Policy 412

Fiscal Policy 416

11.4 The Keynesian Theory of Business Cycles

and Macroeconomic Stabilization 419

Keynesian Business Cycle Theory 419 Macroeconomic Stabilization 422

APPLICATION The Zero Bound 424 Supply Shocks in the Keynesian Model 427

BOX 11.2 DSGE Models and the Classical-Keynesian Debate 429

Appendix 11.A Labor Contracts and

Appendix 11.B Worked-Out Numerical Exercise for Calculating the Multiplier in a Keynesian Model 439

Appendix 11.C The Multiplier

in the Keynesian Model 441

CHAPTER 12

Its Enviro nt and Institutions 443

Unemployment and Inflation 444

12.1 Unemployment and Inflation:

xii Detailed Contents

12 2 The Problem of Unemployment 458

The Costs of Unemployment 458

The Long-Term Behavior of the Unemployment Rate 459

12.3 The Problem of Inflation 462

The Costs of Inflation 462

BOX 12.2 Indexed Contracts 464

Fighting Inflation: The Role of Infla tionary Expecta tions 466 BOX 12.3 The Sacrifice Ratio 468

The U.s Disinflation of the

1980s and 1990s 469

CHAPTER 13

Exchange Rates, B usi ness Cycles,

and Macroeconomic Policy i n the

Open Economy 476

13.1 Exchange Rates 477

Nominal Exchange Rates 477

Real Exchange Rates 478 Appreciation and Depreciation 480 Purchasing Power Parity 480

BOX 13.1 McParity 481

The Real Exchange Rate and Net Exports 483 APPLICATION The Value of the Dollar

and U.S Net Exports 485

13.2 How Exchange Rates Are Determined:

A Supply-and-Demand Analysis 487

In Touch with the Macroeconomy:

Exchange Rates 487 Macroeconomic Determinants of the Exchange Rate and Net Export Demand 489

13 3 The IS-LM Model for an

Open Economy 492

The Open-Economy IS Curve 493

Factors That Shift the Open-Economy

IS Curve 495 The International Transmission

of Business Cycles 498

13 4 Macroeconomic Policy in an Open Economy

with Flexible Exchange Rates 499

A Fiscal Expansion 499

A Monetary Contraction 502

13 5 Fixed Exchange Rates 504

Fixing the Exchange Rate 505

Monetary Policy and the Fixed Exchange Rate 508 Fixed Versus Flexible Exchange Rates 511

Currency Unions 511

APPLICATION European Monetary Unification 512

APPLICATION Crisis in Argentina 515

Appendix 13.A Worked-Out Numerical Exercise for the Open-Economy

IS-LM Model 523

Appendix 13.B An Algebraic Version

of the Open-Economy IS-LM Model 526

The Money Supply with Both Public Holdings

of Currency and Fractional Reserve Banking 535 Open-Market Operations 537

APPLICATION The Money Multiplier

During the Great Depression 538

14.2 Monetary Control in the United States 541

The Federal Reserve System 541

The Federal Reserve's Balance Sheet and Open-Market Operations 542 Other Means of Controlling the Money Supply 543 Intermediate Targets 547

Making Monetary Policy in Practice 550

14.3 The Conduct of Monetary Policy: Rules

Versus Discretion 552

BOX 14.1 The Credit Channel

of Monetary Policy 553

BOX 14.2 The Taylor Rule 554

The Monetarist Case for Rules 555 Rules and Central Bank Credibility 557

APPLICATION Money-Growth Targeting

and Inflation Targeting 563

Other Ways to Achieve Central Bank

Credibility 566

CHAPTER 15

Government Spending

and Its Financing 573

15 1 The Government Budget:

Some Facts and Figures 573

Government Outlays 573 Taxes 575

Deficits and Surpluses 579

15.2 Government Spending, Taxes,

and the Macroeconomy 581

Fiscal Policy and Aggregate Demand 581

Government Capital Formation 583 Incentive Effects of Fiscal Policy 584

APPLICATION Labor Supply and Tax

Reform in the 1980s 586

Detailed Contents

15.3 Government Deficits and Debt 589

The Growth of the Government Debt 589

APPLICATION Social Security:

How Can It Be Fixed? 591

The Burden of the Government Debt on Future Generations 594

Budget Deficits and National Saving: Ricardian Equivalence Revisited 594

Departures from Ricardian Equivalence 597

15.4 Deficits and Inflation 5 98

The Deficit and the Money Supply 598

Real Seignorage Collection and Inflation 600

Appendix 15.A The Debt-GOP Ratio 609

Appendix A

Some Useful Analytical Tools 610

A.l Functions and Graphs 610 A.2 Slopes of Functions 611

xiv Detailed Contents

1 Measures of Aggregate Saving 38

2 Comparing the Benefits and Costs of Changing

the Amount of Labor 75

3 Factors That Shift the Aggregate

Labor Demand Curve 79

4 Factors That Shift the Aggregate

Labor Supply Curve 85

5 Determinants of Desired National Saving 125

6 Determinants of Desired Investment 137

7 Equivalent Measures of a Country's

International Trade and Lending 182

8 The Fundamental Determinants

of Long-Run Living Standards 232

9 Macroeconomic Determinants

of the Demand for Money 260

10 The Cyclical Behavior of Key Macroeconomic

Variables (The Business Cycle Facts) 293

11 Factors That Shift the

Full-Employment (FE) Line 312

12 Factors That Shift the IS Curve 315

13 Factors That Shift the LM Curve 321

14 Factors That Shift the AD Curve 340

15 Terminology for Changes

That Shift the IS Curve 498

19 Factors Affecting the Monetary Base, the Money

Multiplier, and the Money Supply 545

Key Diagrams

1 The production function 102

2 The labor market 103

3 The saving-investment diagram 149

4 National saving and investment

in a small open economy 205

5 National saving and investment

in large open economies 206

7 The aggregate demand-aggregate

supply model 346

8 The misperceptions version

of the AD-AS model 389

re ace

ince February 2006, Ben Bernanke has been chairman of the Board of Governors

of the Federal Reserve System Federal ethics rules prohibited him from making substantive contributions to the sixth edition Dean Croushore, associate pro­fessor of economics and Rigsby Fellow at the University of Richmond, has helped prepare this new edition as a coauthor Dean has been closely associated with Macro­ economics since the first edition, having written or co-written the Instructor's Manual

and Test Bank for the first through fifth editions, the Study Guide for the third through fifth editions, and having assisted with manuscript preparation in previous editions, taking a major role in the fifth edition Dean has been able to draw on his fourteen years of experience at the Federal Reserve Bank of Philadelphia, twelve of which as head of the Macroeconomics Section, as well as his teaching experience at Penn State University, Temple University, the Wharton School of the University of Pennsylvania, Johns Hopkins University, Princeton University, and the University of Richmond, to help keep the book fresh, applied to real-world economic developments, and appealing to students

In the sixth edition, we have added new material to keep the text up-to-date, while building on the strengths that underlie the book's lasting appeal to instruc­tors and students, including:

Real-world applications A perennial challenge for instructors is to help stu­dents make active use of the economic ideas developed in the text The rich variety of applications in this book shows by example how economic concepts can be put to work in explaining real-world issues such as the contrasting behavior of unemployment in the United States and Europe, the slowdown and revival in productivity growth, the challenges facing the Social Security system and the Federal budget, the impact of globalization on the u.s economy, and alternative approaches to making monetary policy The sixth edition offers new applications as well as updates of the best applications and analyses of previous editions

Broad modern coverage From its conception, Macroeconomics has responded to students' desires to investigate and understand a wider range of macroeconomic issues than is permitted by the course's traditional emphasis on short-run fluc­tuations and stabilization policy This book provides a modern treatment of these traditional topics but also gives in-depth coverage of other important macro­economic issues such as the determinants of long-run economic growth, the trade balance and financial flows, labor markets, and the institutional framework

of policymaking This comprehensive coverage also makes the book a useful tool for instructors with differing views about course coverage and topic sequence Reliance on a set of core economic ideas Although we cover a wide range of topics,

we avoid developing a new model or theory for each issue Instead we empha­size the broad applicability of a set of core economic ideas (such as the produc­tion function, the trade-off between consuming today and saving for tomorrow, and supply-demand analysis) Using these core ideas, we build a theoretical

xv

xvi Preface

framework that encompasses all the macroeconomic analyses presented in the book: long-run and short-run, open-economy and closed-economy, and classi­cal and Keynesian

A balanced presentation Macroeconomics is full of controversies, many of which arise from the split between classicals and Keynesians (of the old, new, and neo-varieties) Sometimes the controversies overshadow the broad common ground shared by the two schools We emphasize that common ground First,

we pay greater attention to long-run issues (on which classicals and Keynesians have less disagreement) Second, we develop the classical and Keynesian analyses of short-run fluctuations within a single overall framework, in which

we show that the two approaches differ principally in their assumptions about how quickly wages and prices adjust Where differences in viewpoint remain for example, in the search versus efficiency-wage interpretations of unemployment we present and critique both perspectives This balanced approach exposes students to all the best ideas in modern macroeconomics At the same time, an instructor of either classical or Keynesian inclination can easily base a course on this book

Innovative pedagogy The sixth edition, like its predecessors, provides a variety

of useful tools to help students study, understand, and retain the material Described in more detail later in the preface, these tools include summary tables, key diagrams, key terms, and key equations to aid students in organiz­ing their study, and four types of questions and problems for practice and developing understanding, including problems that encourage students to do their own empirical work, using data readily available on the Internet Several appendices illustrate how to solve numerical exercises that are based on the algebraic descriptions of the IS-LM/AS-AD model

of new and updated topics:

Long-term economic growth Because the rate of economic growth plays a central role in determining living standards, we devote much of Part 2 to growth and related issues We first discuss factors contributing to growth, such as produc­tivity (Chapter 3) and rates of saving and investment (Chapter 4); then in Chapter 6 we turn to a full-fledged analysis of the growth process, using tools such as growth accounting and the Solow model Growth-related topics covered include the post-1973 productivity slowdown, the factors that determine long­

run living standards, and the productivity "miracle" of the 1990s New to this edition:

The text now includes a discussion of the recent growth of China's economy

International macroeconomic issues We address the increasing integration of the world economy in two ways First, we frequently use cross-country compar­isons and applications that draw on the experiences of nations other than the United States For example, in Chapter 3, we compare U.s and European labor markets; in Chapter 6 we compare the long-term economic growth rates

•

CHAPTER

•

• acroecono m lcs

1.1 What Macroeconomics Is About

2

Macroeconomics is the study of the structure and performance of national economies and of the policies that governments use to try to affect economic per­formance The issues that macroeconomists address include the following:

What determines a nation's long-run economic growth? In 1870, income per capita was smaller in Norway than in Argentina But today, income per capita is about three times as high in Norway as in Argentina Why do some nations' economies grow quickly, providing their citizens with rapidly improving living standards, while other nations' economies are relatively stagnant?

What causes a nation's economic activity to fluctuate? After nearly a decade of pros­perity during the 1980s, the U.s economy began to falter in 1990 By the spring

of 1991, output in the United States had fallen by more than 1.5% from its level nine months earlier Economic growth was slow for a few more years before rising sharply in 1994 But then, for the remainder of the 1990s, the U.s econo­

my grew rapidly Why do economies sometimes experience sharp short-run fluctuations, lurching between periods of prosperity and periods of hard times?

What causes unemployment? During the 1930s, one-quarter of the work force in the United States was unemployed A decade later, during World War II, less than 2% of the work force was unemployed Why does unemployment some­times reach very high levels? Why, even during times of relative prosperity, is

a significant fraction of the work force unemployed?

What causes prices to rise? The rate of inflation in the United States crept steadi­

ly upward during the 1970s, and exceeded 10% per year in the early 1980s, before dropping to less than 4% per year in the mid 1980s and dropping even further to less than 2% per year in the late 1990s Germany's inflation experi­ence has been much more extreme: Although Germany has earned a reputation for low inflation in recent decades, following its defeat in World War I Germany experienced an eighteen-month period (July 1922-December 1923) during which prices rose by a factor of several billion! What causes inflation and what can be done about it?

1.1 What Macroeconomics Is About 3

How does being part of a global economic system affect nations' economies? In the late 1990s, the U.s economy was the engine of worldwide economic growth The wealth gained by Americans in the stock market led them to increase their spending on consumer goods, including products made abroad, spurring greater economic activity in many countries How do economic links among nations, such as international trade and borrowing, affect the performance of individual economies and the world economy as a whole?

Can government policies be used to improve a nation's economic performance? In the 1980s and 1990s, the U.s economy's output, unemployment rate, and inflation rate fluctuated much less than they did in the 1960s and 1970s Some econo­mists credit good goverrunent policy for the improvement in economic per­formance How should economic policy be conducted so as to keep the economy as prosperous and stable as possible?

Macroeconomics seeks to offer answers to such questions, which are of great practical importance and are constantly debated by politicians, the press, and the public In the rest of this section, we consider these key macroeconomic issues in more detail

long - R u n E c o n o m i c G rowth

If you have ever traveled in a developing country, you could not help but observe the difference in living standards relative to those of countries such as the United States The problems of inadequate food, shelter, and health care experienced by the poorest citizens of rich nations often represent the average situation for the people

of a developing country From a macroeconomic perspective, the difference between

rich nations and developing nations may be summarized by saying that rich nations have at some point in their history experienced extended periods of rapid economic growth but that the poorer nations either have never experienced sustained growth

or have had periods of growth offset by periods of economic decline

Figure 1.1 summarizes the growth in output of the U.s economy since 1869.1 The record is an impressive one: Over the past century and a third, the annual output of U.s goods and services has increased by more than 100 times The performance of the u.s economy is not unique, however; other industrial nations have had similar, and

in some cases higher, rates of growth over the same period of time This massive increase in the output of industrial economies is one of the central facts of modern his­tory and has had enormous political, military, social, and even cultural implications

In part, the long-term growth of the U.s economy is the result of a rising pop­ulation, which has meant a steady increase in the number of available workers But another significant factor is the increase in the amount of output that can be pro­duced with a given amount of labor The amount of output produced per unit of labor input for example, per worker or per hour of work is called average labor productivity Figure 1 2 shows how average labor productivity, defined in this case as output per employed worker, has changed since 1900 In 2005, the average U.s worker produced more than six times as much output as the average worker

'Output is measured in Fig 1.1 by two very similar concepts, real gross national product (real GNP) until 1929 and real gross domestic product (real GOP) since 1929, both of which measure the physical volume of production in each year We discuss the measurement of output in detail in Chapter 2

4 Chapter 1 Introduction to Macroeconomics

Figure 1 1

Output of the U.S

economy, 1869-2005

In this graph the output

of the U.s economy is

measured by real gross

domestic product (real

GOP) for the period

1929-2005 and by real

gross national product

(real GNP) for the period

prior to 1929, with goods

and services valued at

their 2000 prices in both

cases (see Chapter 2)

Note the strong upward

trend in output over

time, as well as sharp

from Christina D Romer,

"The Prewar Business Cycle

Reconsidered : New Estimates

of Gross National Product,

1869-1908," Jotlmal of Political

Economy, 97, 1 (February 1989),

pp 22-23; real CDP 1929-2005

from FRED database, Federal

Reserve Bank of St Louis,

resen rell sf lOll isfcd orglfred 2/seriesl

COpeA Data from Romer

were rescaled to 2000 prices

Although the long-term record of productivity growth in the U.s economy is excellent, productivity growth slowed from the early 1970s to the mid-1990s and only recently has picked up Output per worker grew about 2.5% per year from

1949 to 1973, but only 1.1 % per year from 1973 to 1995 More recently, from 1995 to

2005, output per worker has increased 2.0% per year, a pace that has improved the health of the U.s economy significantly

Because the rates of growth of output and, particularly, of output per worker ultimately determine whether a nation will be rich or poor, understanding what determines growth is one of the most important goals of macroeconomics Unfor­tunately, explaining why economies grow is not easy Why, for example, did resource-poor Japan and Korea experience growth rates that transformed them in a generation or two from war-torn nations into industrial powers, whereas several resource-rich nations of Latin America have had erratic or even negative growth in recent years? Although macroeconomists have nothing close to a complete answer

to the question of what determines rates of economic growth, they do have some ideas to offer For example, as we discuss in some detail in this book, most macro­economists believe that rates of saving and investment are important for growth Another key determinant of growth we discuss is the rate at which technological change and other factors help increase the productivity of machines and workers

B usi ness Cyc l es

If you look at the history of U.s output in Fig 1 1, you will notice that the growth

of output isn't always smooth but has hills and valleys Most striking is the period between 1929 and 1945, which spans the Great Depression and World War II During the 1929-1933 economic collapse that marked the first major phase of the

Average labor produc­

tivity (output per

employed worker) has

risen over time, with a

peak during World War II

reflecting increased

wartime production

Productivity growth was

particularly strong in the

19505 and 19605, slowed

in the 19705, and picked

up again in the mid

19905 For the calculation

of productivity, output is

measured as in Fig l.l

Sources: Employment in

thousands of workers 14 and

older for 1 900-1947 from

Historical Stntistics of the Ullited

States, Colollial Times to 1970,

pp 126�127; workers 16 and

older for 1948-2005 from

FRED database, Federal

Reserve Bank of St Louis,

research stlouisfed.orglfred/ series/

CE160V Average labor pro­

ductivity is output divided by

employment, where output is

�

AVERAGE LABOR PRODUCTIVITY

\

1.1 What Macroeconomics Is About 5

1 950s-1960s productivity speedup

\

1 970s

productivity slowdown

\

Mid-1990s productivity speedup

1945 have been as severe as those of the 1929-1945 period However, during the postwar era there have been periods of unusually rapid economic growth, such as during the 1960s and 1990s, and times during which output actually declined from one year to the next, as in 1973-1975, 1981-1982, and 1990-199l

Macroeconomists use the term business cycle to describe short-run, but some­times sharp, contractions and expansions in economic activity.2 The downward phase of a business cycle, during which national output may be falling or perhaps growing only very slowly, is called a recession Even when they are relatively mild, recessions mean hard economic times for many people Recessions are also a major political concern, because almost every politician wants to be reelected and the chances of reelection are better if the nation's economy is expanding rather than declining Macroeconomists put a lot of effort into trying to figure out what causes business cycles and deciding what can or should be done about them In this book

we describe a variety of features of business cycles, compare alternative explana­tions for cyclical fluctuations, and evaluate the policy options that are available for affecting the course of the cycle

U n e m p l oy m e nt

One important aspect of recessions is that they usually are accompanied by an increase in unemployment, or the nwnber of people who are available for work and are actively seeking work but cannot find jobs Along with growth and business cycles, the problem of unemployment is a third major issue in macroeconomics

2A more exact definition is given in Chapter 8 Business cycles do not inc1ude fluctuations lasting only

a few months, such as the increase in activity that occurs around Christmas

6 Chapter 1 Introduction to Macroeconomics

Figure 1 3

The U.S

unemployment rate,

1890-2005

The figure shows the

percentage of the civilian

labor force (excluding

people in the military)

that was unemployed in

each year since 1890

Unemployment peaked

during the depression of

the 18905 and the Great

Depression of the 1930s,

and reached low points

in 1920 and during

World War II Since

World War II, the highest

unemployment rate (people

aged 14 and older until 1 947,

aged 16 and older after 1947)

for 1 890-1947 from Historical

Stntistics of the Ullited Stntes,

Colol1ial Times to 1 970,

p 135; for 1945 2()()S from FRED

database Federal Reserve Bank

.9< 1 5

1 0

5

1 890s depression

Great Depression

/

U N EMPLOYMENT RATE

The best-known measure of unemployment is the unemployment rate, which

is the number of unemployed divided by the total labor force (the number of people either working or seeking work) Figure 1.3 shows the unemployment rate

in the United States over the past century The highest and most prolonged period

of unemployment occurred during the Great Depression of the 1930s In 1933, the unemployment rate was 24.9%, indicating that about one of every four potential workers was unable to find a job In contrast, the tremendous increase in economic activity that occurred during World War II significantly reduced unemployment In

1944, at the peak of the wartime boom, the unemployment rate was 1.2%

Recessions have led to significant increases in unemployment in the postwar period For example, during the 1981-1982 recession the U.s unemployment rate reached 10.8% 3 Even during periods of economic expansion, however, the unem­ployment rate remains well above zero, as you can see from Fig 1 3 In 2000, after nine years of economic growth with no recession, the unemployment rate was still about 4% Why the unemployment rate can remain fairly high even when the econ­omy as a whole is doing well is another important question in macroeconomics

I nflation

When the prices of most goods and services are rising over time, the economy is said to be experiencing inflation Figure 1.4 shows a measure of the average level

3The unemployment rate was 10.8% in November and December 1982 The unemployment rate plotted

in Fig 1.3 is not this high because the graph only shows annual data-the average unemployment rate over the 12 months of each year-which was 9.7% in 1982

Figure 1 4

Consumer prices in

the United States,

1800-2005

Prior to World War II, the

average level of prices

faced by consumers

remained relatively flat,

with periods of inflation

(rising pr i c e s ) offset by

periods of deflation

(falling prices) Since

World War II, however,

prices have risen more

than tenfold In the

figure, the average level

of prices is measured by

the consumer price index,

or CPJ (see Chapter 2)

The cpr measures the

cost of a fixed set, or

basket, of consumer

goods and services rela­

tive to the cost of the

same goods and services

in a base period-in this

case, 1982-1984 Thus a

cpr of 195.30 in 2005

means that a basket of

consumer goods and

services that cost $100 in

1982-1984 would cost

$195.30 in 2005

Sources: Consumer price index,

1800-1946 (1967 = 100) from

Historical Statistics of the Ullited

States, Colollial Times to 1970,

pp 210-211; 1947-2005

(1982-1984 = 100) from FRED

database, Federal Reserve

Bank of St Louis, researc1l

5 t 1011 is fed orglfred 21ser ies!

CPIAUCSL Data prior to 1971

were rescaled to a base with

The last significant deflation in the United States occurred during 1929-1933, the initial phase of the Great Depression Since then, inflation, without offsetting deflation, has become the normal state of affairs, although inflation was fairly low

in the 1990s and early 2000s Figure 1 4 shows that consumer prices have risen sig­nificantly since World War II, with the measure of prices shown increasing tenfold

The percentage increase in the average level of prices over a year is called the inflation rate If the inflation rate in consumer prices is 10%, for example, then on average the prices of items that consumers buy are rising by 10% per year Rates of inflation may vary dramatically both over time and by country, from 1 or 2 percent per year in low-inflation countries (such as Switzerland) to 1000% per year or more

in countries (such as a number of the former Soviet republics in the early 1990s) that are experiencing hyperinflations, or extreme inflations When the inflation rate reaches an extremely high level, with prices changing daily or hourly, the economy tends to function poorly High inflation also means that the purchasing power of money erodes quickly This situation forces people to scramble to spend their money almost as soon as they receive it

4This measure is called the consumer price index, or CPT, which is discussed in Chapter 2 Conceptu­ ally, the CPI is intended to measure the cost of buying a certain fixed set, or "basket," of consumer goods and services However, the construction of a consumer price index over a period as long as two centuries involves many compromises For instance, the basket of goods and services priced by the

CPT is not literally the same over the entire period shown in Fig 1.4 but is periodically changed to reflect the different mix of consumer goods and services available at different times

8 Chapter 1 Introduction to Macroeconomics

Figure 1 5

U.S exports and

imports, 1869-2005

The figure shows U.s

exports (black) and U.S

imports (red), each

expressed as a percent­

age of total output

Exports and imports

need not be equa I in each

year: U.s exports

exceeded imports

(shaded gray) during

much of the twentieth

century During the

1980s, 19905 and early

20005, however, U.s

exports were smaller

than U.s imports

(shaded red)

Sources: Imports and exports of

goods and services: 1869-1959

United States, Colonial Times

to 1970 pp 864-865;

1960-2005 from FRED

database, Federal Reserve

st lOll isf c d org/fred2/series/B 0 P X

and BOPM; output is from

Fig 1 1

The Int e rnati ona l Economy

Today every major economy is an open economy, or one that has extensive trading and financial relationships with other national economies (In contrast, a closed economy doesn't interact economically with the rest of the world.) Macroecono­mists study patterns of international trade and borrowing to understand better the links among national economies For example, an important topic in macroeco­nomics is how international trade and borrowing relationships can help transmit business cycles from country to country

Another issue for which international considerations are central is trade imbal­ances Figure 1.5 shows the historical behavior of the imports and exports of goods and services by the United States U.s imports are goods and services produced abroad and purchased by people in the United States; U.s exports are goods and services produced in the United States and sold to people in other countries To give you a sense of the relative importance of international trade, Fig 1.5 expresses exports and imports as percentages of total U.s output Currently, both exports and imports are larger fractions of U.s output than they were during the 1950s and

World War II

O u- � � � � L- L- L- L-� � � � � �� _

1 870 1880 1 890 1 900 1 9 1 0 1 920 1 930 1 940 1 950 1 960 1 970 1 980 1 990 20002005

Year

1.1 What Macroeconomics Is About 9

1960s, reflecting both the recovery of trade from the disruptions of the Great Depression and World War II and the trend toward greater economic interdepen­dence among nations Note, though, that a century ago exports and imports already were important relative to the size of the overall economy

Figure 1 5 demonstrates that exports and imports need not be equal in each year For example, following World War I and World War II, U.s exports out­stripped U.s imports because the country was sending large quantities of supplies

to countries whose economies had been damaged by war When exports exceed imports, a trade surplus exists In the 1980s, however, U.s exports declined sharply relative to imports, a situation that has persisted through the 1990s and into the 2000s, as you can see from Fig 1.5 This recent excess of imports over exports, or

trade deficit, has received considerable attention from policymakers and the news media What causes these trade imbalances? Are they bad for the U.s economy or for the economies of this country's trading partners? These are among the ques­tions that macroeconomists try to answer

M a cr o e c o n o m i c P o l i cy

A nation's economic performance depends on many factors, including its natural and human resources, its capital stock (buildings, machines, and software), its technology, and the economic choices made by its citizens, both individually and collectively Another extremely important factor affecting economic performance is the set of macroeconomic policies pursued by the government

Macroeconomic policies affect the performance of the economy as a whole The two major types of macroeconomic policies are fiscal policy and monetary policy Fiscal policy, which is determined at the national, state, and local levels, concerns government spending and taxation Monetary policy determines the rate of growth of the nation's money supply and is under the control of a government institution known as the central bank In the United States, the central bank is the Federal Reserve System, or the Fed

One of the main macroeconomic policy issues of recent years in the United States has been in the realm of fiscal policy Large Federal budget surpluses emerged in the late 1990s, but these gave way to large Federal budget deficits, exceeding $300 billion each year from 2003 to 2005 The recent behavior of the Federal budget is put into a long-term perspective in Fig 1 6, which presents data

on Federal government spending and tax revenues for the past century and a third 5 Again, so that their importance relative to the economy as a whole is indi­cated, spending, tax collections, and government budget deficits and surpluses are expressed as percentages of total output

Two obvious features of Fig 1.6 are the peaks in government spending and deficits that resulted from military buildups in World War I and World War II At its high point during World War II, Federal government spending exceeded 43%

of total output Significant deficits also occurred during the Great Depression of the 1930s because the government increased its spending on various programs designed to help the economy, such as government-financed jobs programs

SGovernment spending includes both government purchases of goods and services, such as purchases

of military equipment and the salaries of government officials, and government benefits paid to indi­ viduals, such as Social Security payments

1 0 Chapter 1 Introduction to Macroeconomics

U.s Federal government

spending (red) and U.s

Federal government tax

collections (black) are

shown as a percentage of

total output Deficits

(excesses of spending

over tax collections) are

shaded red, and surpluses

(excesses of taxes over

spending) are shaded

gray The government

sector's share of the

economy has grown

since World War II Large

deficits occurred during

the two world wars, the

Grea t Depression, and

during the 1980s and

much of the 1990s

Sources: Federal spending and

receipts: 1869-1929 from

Historical Statistics afthe Ullited

States, Colonial Times to 1970,

p 1104; 1930 onward from

Historical Tables, Budget of the

U.S GovemmeJ1l, Table 1.2;

Output, 1869-1928 (GNP)

from Christina O Romer,

"The Prewar Business Cycle

Reconsidered: New Estimates

of Gross National Product,

Great Depression

\

TAXES

Federal government deficits of the

1980s and early and mi 1 990s

Federal government surpluses of 1 998

The possible link between the government's budget deficit and the trade imbal­ance illustrates an important aspect of macroeconomics: Macroeconomic issues and problems are frequently interconnected For this reason, studying one macro­economic question, such as the effects of the government budget deficit, in isolation generally is not sufficient Instead, macroeconomists usually study the economy as

a complete system, recognizing that changes in one sector or market may affect the behavior of the entire economy

Aggregation

Macroeconomics is one of two broad areas within the field of economics, the other being microeconomics Macroeconomics and microeconomics have many basic eco­nomic ideas and methods in common; the difference between them is the level at which the economy is studied Microeconomists focus on individual consumers,

1 2 What Macroeconomists Do 1 1

workers, and firms, each of which is too small to have an impact on the national economy Macroeconomists ignore the fine distinctions among the many different kinds of goods, firms, and markets that exist in the economy and instead focus on national totals For example, in their analyses macroeconomists do not care whether consumers are buying Microsoft Xboxes or Sony PlayStations, beef or chicken, Pepsi

or Coke Instead, they add consumer expenditures on all goods and services to get

an overall total called aggregate consumption The process of summing individual economic variables to obtain economywide totals is called aggregation The use of aggregation and the emphasis on aggregate quantities such as aggregate consump­tion, aggregate investment, and aggregate output are the primary factors that dis­tinguish macroeconomics from microeconomics

How do macroeconomists use their skills, and what do they do with all the data they gather and the theories they develop? Besides teaching economics, macro­economists engage in a wide variety of activities, including forecasting, macroeco­nomic analysis, basic research, and data development for government, nonprofit organizations, and private businesses

M a cr o e c o n o m i c Fore c ast i n g

Many people believe that economists spend most of their time trying to forecast the performance of the economy In fact, except for a relatively small number of fore­casting specialists, forecasting is a minor part of what macroeconomists do One reason macroeconomists don't emphasize forecasting is that on the whole they are not terribly good at it! Forecasting is difficult not only because our understanding

of how the economy works is imperfect, but also because it is impossible to take into account all the factors many of them not strictly economic that might affect future economic trends Here are some questions that a forecaster, in trying to pro­ject the course of the economy, might have to try to answer: How will events abroad affect congressional authorizations for military spending over the next few years? What oil price will the Organization of Petroleum Exporting Countries (OPEC) decide on at its next meeting? Will there be a severe drought in agricultural regions, with adverse effects on food quantities and prices? Will productivity rise

as rapidly in the future as it did in the late 1990s and early 2000s as businesses increasingly adopted computer technology? Because answers to such questions are highly uncertain, macroeconomic forecasters rarely offer a single prediction Instead, they usually combine a "most likely" forecast with "optimistic" and

"pessimistic" alternative scenarios

Does the fact that macroeconomics can't be used to make highly accurate fore­casts of economic activity mean that it is a pointless field of study? Some people may think so, but that's really an unreasonable standard Meteorology is an exam­ple of a field in which forecasting is difficult (will it definitely be sunny this week­end?) but in which there is also a lot of useful knowledge (meteorologists helped discover the depletion of the earth's ozone layer and pointed out its dangers) Sim­ilarly, cardiologists usually can't predict if or when a patient will have a heart attack they can only talk about probabilities Like meteorologists and doctors,

1 2 Chapter 1 Introduction to Macroeconomics

economists deal with a system whose complexity makes gaining a thorough lUlder­standing difficult and forecasting the system's behavior even more difficult Rather than predicting what will happen, most macroeconomists are engaged in analyzing and interpreting events as they happen (macroeconomic analysis) or in trying to understand the structure of the economy in general (macroeconomic research)

The public sector, wlUch includes national and regional governments and inter­national agencies such as the World Bank and the International Monetary Fund, also employs many macroeconomic analysts The main function of public-sector analysts is to assist in policymaking for example, by writing reports that assess various macroeconomic problems and by identifying and evaluating possible policy options Among U.s policymakers, the officials who set monetary policy may call on the aid of several hundred Ph.D economists employed within the Federal Reserve System, and the President has the advice of the Council of Eco­nomic Advisers and the professional staffs of numerous departments and agencies For members of Congress, a frequent source of macroeconomic analysis is the Congressional Budget Office Economic policymakers also often go outside the government to seek the advice of macroeconomists from business or academia

If a country has many well-trained macroeconomic analysts, as is true in the United States, does that mean that its macroeconomic policies will always be intel­ligent and farsighted? The answer, unfortunately, is "no." Because of the complexity

of the economy, macroeconomic policy analysis, like macroeconomic forecasting, often is difficult and uncertain Perhaps even more important, politicians, not econ­ omists, often make economic policy Politicians are typically less concerned with the abstract desirability of a policy than with the policy's immediate effects on their constituents Thus in late 1990 international talks intended to reduce trade barriers failed because European governments found it politically inadvisable to reduce high subsidy payments to their farmers despite the nearly universal opposition of economists to both trade barriers and farm price support payments In 2002, the Bush administration gave in to pressure from the steel industry and imposed tar­iffs on certain types of imported steel despite the nearly universal opposition of economists to trade barriers

Although the technical advice provided by macroeconomic analysts is not the sole basis on which macroeconomic policy is made, such advice is probably neces­sary for making good policy decisions, especially if dramatic changes are being con­sidered Since the 1990s, for example, a number of countries in Eastern Europe, Latin America, and elsewhere have lUldertaken radical reforms of their economies In most of these cases, the colUltries' leaders have sought the technical advice of domes­tic and foreign economists, and tlUs advice has been influential in policymaking In the former Soviet Union, economists have played an important role in the debate over restructuring and reform, both as technical specialists and as political advocates

M a c r o e c o n o m i c Research

1.2 What Macroeconomists Do 13

Macroeconomic research takes an amazing variety of forms, from abstract mathe­matical analysis to psychological experimentation to simulation projects in which computers are used to generate random numbers that represent the randomness of day-to-day economic activity Nevertheless, the goal of all macroeconomic research

is to make general statements about how the economy works The general insights about the economy gained from successful research form the basis for the analyses

of specific economic problems, policies, or situations

To see why research is important, imagine that you are an economist with the International Monetary Fund whose task is to help a small African country control its high rate of inflation On what basis can you offer advice? Basically, you should know what inflation-fighting policies other countries have used in the past, what the results have been, how the results have depended on the characteristics of the country employing the policy, and so on Particularly if the situation you are ana­lyzing is not identical to any of the previous cases, having some theoretical princi­ples would also help you identify and understand the main factors contributing to that country's inflation Analyzing the historical cases and working out the theo­retical principles by yourself from scratch might involve many years' effort The value of ongoing research activities is that many of the results and ideas that you need will already be available in books or professional journals or circulated in unpublished form Because it forms the basis for activities such as economic analy­sis and forecasting, in a very real sense macroeconomic research is the engine that pulls the whole enterprise of macroeconomics behind it

Macroeconomic research takes place primarily in colleges and universities, in nonprofit institutions (such as the National Bureau of Economic Research, the Brook­ings Institution, and the American Enterprise Institute), and in the public sector (the government and international agencies) Particularly in the public sector, the line between economic analysis and macroeconomic research is much fuzzier than we have drawn it here The reason is that many economists move back and forth between analysis of specific problems (such as an African country's inflation problem) and more basic macroeconomic research (such as an analysis of inflation in general)

Economic Theory How is macroeconomic research carried out? As in many other fields, macroeconomic research proceeds primarily through the formulation and testing of theories An economic theory is a set of ideas about the economy that has been organized in a logical framework Most economic theories are developed

in terms of an economic model, which is a simplified description of some aspect of the economy, usually expressed in mathematical form Economists evaluate an economic model or theory by applying four criteria:

1 Are its assumptions reasonable and realistic?

2 Is it understandable and manageable enough to be used in studying real

problems?

3 Does it have implications that can be tested by empirical analysis? That is, can

its implications be evaluated by comparing them with data obtained in the real world?

4 When the implications and the data are compared, are the implications of the

theory consistent with the data?

1 4 Chapter 1 Introduction to Macroeconomics

Deve loping and Testing a n Economic Theory

To illustrate the process of developing and testing an

economic theory, suppose that we want to develop a

theory that explains the routes that people take when

they commute from home to work and back Such a

theory would be useful, for example, to a traffic planner

who is concerned about how a proposed housing devel­

opment wiIJ affect traffic patterns Here are the steps we

would take

Step 1 State the research question

Example: What determines traffic flows in the city

during rush hours?

economic setting and the behavior of the economic

actors These assumptions should be simple yet capture

the most important aspects of the problem

Example: The setting is described by the map of the city

The assumption about behavior is that commuters

choose routes that minimize driving time

Step 3 Work out the implications of the theory

Example: Use the map of the city to plot a route that min­

imizes driving time between home and place of work

implications of the theory with the data

Example: Conduct a survey of commuters to identify (1)

home locations; (2) work locations; and (3) routes taken

to work Then determine whether the routes predicted

by the model are generally the same as those reported in the comm uter survey

Step 5 Evaluate the results of your comparisons

If the theory fits the data well: Use the theory to predict what would happen if the economic setting or economic policies change

Example: Use the minimum-driving-time assumption to evaluate the traffic effects of a new housing develop­ ment by figuring out which routes the residents of the development are likely to take

If the theory fits the data poorly: Start from scratch with a new model Repeat Steps 2-5

Example: Change the provisional behavioral assumption

to the following: Commuters choose the route that min­ imizes the distance they must drive (not the time they spend driving)

If the theory fits the data moderately well: Either make do with a partially successful theory or modify the model with additional assumptions and then repeat Steps 3-5

Example: A possible modification of the minimum-driving­ time assumption is that commuters will choose more scenic over less scenic routes, if driving time is not increased by more than a certain number of minutes To test the model with this modified assumption, you must determine which routes are more scenic (those that pass

a lake) and which are less scenic (those that pass a dump)

For a theory or model of any type, not just economic to be useful, the answer to each of these questions must be "yes." Unfortunately, though, econo­mists may not always agree in their evaluation of a particular model, with the result that controversies sometimes persist about the best way to model a given economic situation

We present a summary of the main steps in developing and testing an eco­nomic theory or model in Box 1.1

Data Developm ent

The collection of economic data is a vital part of macroeconomics, and many econ­omists are involved in the data development process In the United States as well

as all other major countries, data on thousands of economic variables are collected and analyzed We have already presented some important macroeconomic data series, such as measures of output and the price level, and will look at these and others in more detail in Chapter 2 Macroeconomists use economic data to assess

1.3 Why Macroeconom ists Disagree 15

the current state of the economy, make forecasts, analyze policy alternatives, and test macroeconomic theories

Most economic data are coUected and published by the Federal government for example, by agencies such as the Bureau of the Census, the Bureau of Labor Statistics, and the Bureau of Economic Analysis in the United States, and by central banks such as the Federal Reserve To an increasing degree, however, these activities also take place in the private sector For example, marketing firms and private economic forecasting companies are important collectors, users, and sellers of economic data

In this book, boxes called "In Touch with the Macroeconomy" describe major macro­economic data series and tell you how they are collected and where to find them

Much of the data collection and preparation process is routine However, because providers of data want their numbers to be as useful as possible while keeping costs down, the organization of major data collection projects is typically the joint effort of many skilled professionals Providers of data must decide what types of data should be collected on the basis of who is expected to use the data and how They must take care that measures of economic activity correspond to abstract concepts (such as "capital" and "labor") that are suggested by economic theory In addition, data providers must guarantee the confidentiality of data that may reveal information about individual firms and people in the economy In a large data­gathering organization such as the Bureau of the Census, each of these issues is exhaustively analyzed by economists and statisticians before data collection begins 6

Over the years, the efforts of thousands of analysts, data collectors, and researchers have greatly enhanced the understanding of macroeconomic phenomena Yet no matter what the macroeconomic issue, the news media seemingly can find an econo­mist to argue either side of it Why do macroeconomists appear to disagree so much?7

To a certain extent, the amount of disagreement among macroeconomists is exaggerated by the tendency of the public and the media to focus on the most dif­ficult and controversial issues In addition, the very fact that economic policy and performance are of such broad interest and concern contributes to the intensity of debate: More than controversies in many other fields, debates in macroeconomics tend to take place in public, rather than in the seminar room or the laboratory Although important disagreements among macroeconomists certainly exist, there also are many areas of substantial agreement in macroeconomics

We can provide an insight into why macroeconomists disagree by drawing the important distinction between positive and normative analyses of economic policy

A positive analysis of an economic policy examines the economic consequences of

a policy but doesn't address the question of whether those consequences are desirable

6For a readable discussion of issues that face data colJectors, see Janet L Norwood, "Distinguished Lecture on Economics in Government: Data Quality and Public Policy," journal of Economic Perspec­

16 Chapter 1 Introduction to Macroeconomics

A n orm ative analysis of policy tries to determine whether a certain policy should be used For example, if an economist is asked to evaluate the effects on the economy

of a 5% reduction in the income tax, the response involves a positive analysis But

if asked whether the income tax should be reduced by 5%, the economist's response requires a normative analysis This normative analysis will involve not only the economist's objective, scientific understanding of how the economy works but also personal value judgments for example, about the appropriate size of the government sector or the amount of income redistribution that is desirable

Economists may agree on the positive analysis of a question yet disagree on the normative part because of differences in values Value differences also are common

in other fields: Physicists may be in perfect agreement on what would happen if a nuclear bomb were detonated (a positive analysis) But physicist "hawks" and physicist "doves" may disagree strongly about whether nuclear weapons should be deployed (a normative question)

Disagreement may occur on positive issues, however, and these differences are important in economics In macroeconomics there always have been many schools

of thought, each with a somewhat different perspective on how the economy works Examples include monetarism and supply-side economics, both of which we dis­cuss in this book However, the most important and enduring disagreements

on positive issues in macroeconomics involve the two schools of thought called the classical approach and the Keynesian approach

C l a s s i c a l s Ve rsus Keyne s i ans

The classical approach and the Keynesian approach are the two major intellectual traditions in macroeconomics We discuss the differences between the two approaches briefly here and in much greater detail later in the book

The Class i c a l Approach The origins of the classical approach go back more than two centuries, at least to the famous Scottish economist Adam Smith In 1776 Smith published his classic, The Wealth of Nations, in which he proposed the concept

of the "invisible hand." The idea of the invisible hand is that, if there are free markets and individuals conduct their economic affairs in their own best interests, the overall economy will work well As Smith put it, in a market economy, indi­viduals pursuing their own self-interests seem to be led by an invisible hand to maximize the general welfare of everyone in the economy

However, we must not overstate what Smith claimed: To say that an invisible hand is at work does not mean that no one in a market economy will be hungry or dissatisfied; free markets cannot insulate a nation from the effects of drought, war,

or political instability Nor does the invisible hand rule out the existence of great inequalities between the rich and the poor, because in Smith's analysis he took the initial distribution of wealth among people as given Rather, the invisible-hand idea says that given a country's resources (natural, human, and technological) and its irtitial distribution of wealth, the use of free markets will make people as econom­ically well off as possible

Validity of the invisible-hand idea depends on a key assumption: The various markets in the economy, including financial markets, labor markets, and markets for goods and services, must function smoothly and without impediments such as minimum wages and interest rate ceilings In particular, wages and prices must adjust rapidly enough to maintain equilibrium a situation in which the quantities

1.3 Why Macroeconom ists Disagree 17

demanded and supplied are equal in all markets In markets where quantity demanded exceeds quantity supplied, prices must rise to bring the market into equilibrium In markets where more of a good is available than people want to buy, prices must fall to bring the market into equilibrium

Wage and price flexibility is crucial to the invisible-hand idea, because in a free­market system, changes in wages and prices are the signals that coordinate the actions of people in the economy To illustrate, suppose that war abroad disrupts oil imports This drop in supply will drive up the price of oil A higher oil price will make it profitable for domestic oil suppliers to pump more oil and to drill more wells The higher price will also induce domestic consumers to conserve oil and to switch to alternative sources of energy Increased demand for alternative energy sources will raise their prices and stimulate their production, and so on Thus, in the absence of impediments such as government price controls, the adjustment of prices helps the free-market economy respond in a constructive and coordinated way to the initial disruption of supplies

The classical approach to macroeconomics builds on Smith's basic assumptions that people pursue their own economic self-interests and that prices adjust rea­sonably quickly to achieve equilibrium in all markets With these two assump­tions as a basis, followers of the classical approach attempt to construct models of the macroeconomy that are consistent with the data and that can be used to answer the questions raised at the beginning of this chapter

The use of the classical approach carries with it some strong policy implications Because the classical assumptions imply that the invisible hand works well, classi­cal economists often argue (as a normative proposition) that the government should have, at most, a limited role in the economy As a positive proposition, classical economists also often argue that government policies will be ineffective or counter­productive at achieving their stated goals Thus, for example, most classicals believe that the government should not try actively to eliminate business cycles

approach is relatively recent The book that introduced it, The General Theory of Employment, Interest, and Money, by British economist John Maynard Keynes, appeared in 1936 160 years after Adam Smith's The Wealth of Nations In 1936 the world was suffering through the Great Depression: Unprecedentedly high rates of unemployment had afflicted most of the world's economies for years, and the invisible hand of free markets seemed completely ineffective From the viewpoint

of 1936, the classical theory appeared to be seriously inconsistent with the data, cre­ating a need for a new macroeconomic theory Keynes provided this theory

In his book, Keynes offered an explanation for persistently high unemployment.s

He based this explanation on an assumption about wage and price adjustment that was fundamentally different from the classical assumption Instead of assuming that wages and prices adjust rapidly to achieve equilibrium in each market, as in the classical tradition, Keynes assumed that wages and prices adjust slowly Slow wage and price adjustment meant that markets could be out of equilibrium with quan­tities demanded not equal to quantities supplied for long periods of time In the Keynesian theory, unemployment can persist because wages and prices don't

'Actually, Keynes presented a number of explanations of unemployment in his book, and debate con­ tinues about "what Keynes really meant." OUf interpretation of what Keynes meant is the one adopted

by his major followers

1 8 Chapter 1 Introduction to Macroeconomics

adjust quickly enough to equalize the number of people that firms want to employ with the number of people who want to work

Keynes's proposed solution to high unemployment was to have the govern­ment increase its purchases of goods and services, thus raising the demand for output Keynes argued that this policy would reduce unemployment because, to meet the higher demands for their products, businesses would have to employ more workers In addition, Keynes suggested, the newly hired workers would have more income to spend, creating another source of demand for output that would raise employment further More generally, in contrast to classicals, Keynesians tend to be skeptical about the invisible hand and thus are more willing to advocate

a role for government in improving macroeconomic performance

The Evolution of the Classical-Keynesian Debate Because the Great Depression

so strongly shook many economists' faith in the classical approach, the Keynesian approach dominated macroeconomic theory and policy from World War II until about 1970 At the height of Keynesian influence, economists widely believed that, through the skillful use of macroeconomic policies, the government could pro­mote economic growth while avoiding inflation or recession The main problems of macroeconomics apparently had been solved, with only some details to be filled in

However, in the 1970s the United States suffered from both high unemploy­ment and high inflation called stagflation, or stagnation plus inflation This experience weakened economists' and policymakers' confidence in the traditional Keynesian approach, much as the Great Depression had undermined the tradi­tional classical approach In addition, the Keynesian assumption that prices and wages adjust slowly, so that markets may be out of equilibrium, was criticized as being without sound theoretical foundations While the Keynesian approach was coming under attack, developments in economic theory made classical macro­economics look more interesting and attractive to many economists Starting in the early 1970s, a modernized classical approach enjoyed a major resurgence among macroeconomic researchers, although classical macroeconomics did not achieve the dominance that Keynesianism had enjoyed in the early postwar years

In the past three decades, advocates of both approaches have reworked them extensively to repair their weaknesses Economists working in the classical tradition have improved their explanations of business cycles and lU1employment Keynesians have worked on the development of sound theoretical foundations for the slow adjustment of wages and prices, and Keynesian models can now accommodate stagflation Currently, excellent research is being conducted with both approaches, and substantial commlU1ication and cross-fertilization are occurring between them

A U n if i e d A p p r o a c h to M a c r o e c o n o m i c s

In writing this book, we needed a strategy to deal with the fact that there are two major macroeconomic schools of thought One strategy would have been to empha­size one of the two schools of thought and to treat the other only briefly The prob­lem with that strategy is that it would not expose you to the full range of ideas and insights that compose modern macroeconomics Alternatively, we might have pre­sented the two approaches separately and then compared and contrasted their conclusions but you would have missed the opportunity to explore the large common ground shared by the two schools of thought

Chapter Summ ary 1 9

Our choice was to take an approach to macroeconomics that is as balanced and unified as possible In keeping with this unified approach, all our analyses in this book whether of economic growth, business cycles, inflation, or policy, and whether classical or Keynesian in spirit are based on a single economic model, or on compo­nents or extensions of the basic model This economic model, which draws heavily from both the classical and Keynesian traditions, has the following characteristics

1 Individuals, firms, and the government interact in goods markets, asset markets, and labor markets We have already discussed the need for aggregation in macro­economics In the economic model of this book we follow standard macroeconomic practice and aggregate all the markets in the economy into three major markets: the market for goods and services, the asset market (in which assets such as stocks, bonds, and real estate are traded), and the labor market We show how participants

in the economy interact in each of these three markets and how these markets relate to one another and to the economy as a whole

2 The model's macroeconomic analysis is based on the analysis of individual behav­ ior Macroeconomic behavior reflects the behaviors of many individuals and firms interacting in markets To understand how individuals and firms behave, we take

a "bottom-up" approach and focus our analysis at the level of individual decision making (as in Box 1.1 where we discuss a model of individual choices about the route to take to work) The insights gained are then used for studying the economy

as a whole

The guiding principle in analyzing the behavior of individuals and firms is the assumption that they try to maximize their own economic satisfaction, given their needs, desires, opportunities, and resources Although the founder of classical economics, Adam Smith, emphasized this assumption, it is generally accepted by Keynesians and classicals alike, and it is used in virtually all modern macroeconomic research

3 Although Keynesians reject the classical assumption that wages and prices quickly adjust to achieve equilibrium in the short run, Keynesians and classicals both agree that, in the long run, prices and wages fully adjust to achieve equilibrium in the markets for goods, assets, and labor Because complete flexibility of wages and prices in the long run

is not controversial, we examine the long-term behavior of the economy (Chapters 3-7) before discussing short-run issues associated with business cycles (Chapters 8-13)

4 The basic model that we present may be used with either the classical assumption that wages and prices are flexible or the KetJnesian assumption that wages and prices are slow

to adjust This aspect of the model allows us to compare classical and Keynesian con­clusions and policy recommendations within a common theoretical framework

C H A P T E R S U M M A RY

1 Macroeconomics is the study of the structure and per­

formance of national economies and the policies that

governments use to try to affect economic perfor­

mance Important topics in macroeconomics include

the determinants of long-run economic growth, busi­

ness cycles, unemployment, inflation, international

trade and lending, and macroeconomic policy

2 Because macroeconomics covers the economy as a

whole, macroeconomists ignore the fine distinctions

among different kinds of goods, firms, or markets and focus on national totals such as aggregate consump­ tion The process of adding individual economic variables to obtain economywide totals is called aggregation

3 The activities engaged in by macroeconomists

include (in addition to teaching) forecasting, macro­ economic analysis, macroeconomic research, and data development

20 Chapter 1 Introduction to Macroeconomics

4 The goal of macroeconomic research is to be able to

make general statements about how the economy

works Macroeconomic research makes progress

toward this goal by developing economic theories

and testing them empirically-that is, by seeing

whether they are consistent with data obtained from

the real world A useful economic theory is based on

reasonable and realistic assumptions, is easy to use,

has implications that can be tested in the real world,

and is consistent with the data and the observed

behavior of the real-world economy

5 A positive analysis of an economic policy examines

the economic consequences of the policy but does not

address the question of whether those consequences

are desirable A normative analysis of a policy tries

to determine whether the policy should be used

Disagreements among macroeconomists may arise

because of differences in normative conclusions, as

inflation, p 6

the result of differences in personal values and beliefs, and because of differences in the positive analysis of a policy proposal

6 The classical approach to macroeconomics is based

on the assumptions that individuals and firms act in their own best interests and tha t wages and prices adjust quickly to achieve equilibrium in all markets Under these assumptions the invisible hand of the free-market economy works well, with only a limited scope for government intervention in the economy

7 The Keynesian approach to macroeconomics assumes

that wages and prices do not adjust rapidly and thus the invisible hand may not work well Keynesians argue that, because of slow wage and price adjust­ ment, unemployment may remain high for a long time Keynesians are usually more inclined than clas­ sicals to believe that government intervention in the economy may help improve economic performance

R E V I E W Q U E S T I O N S

Questions marked with a brown circle are available in

MyEconLab at www myecon l ab.com

1 How have total output and output per worker

changed over time in the United States? How have

these changes affected the lives of typical people?

What is a business cycle? How does the unemploy­

ment rate behave over the course of a business cycle?

Does the unemployment rate ever reach zero?

Define inflation and deflation Compare the behavior

of consumer prices in the United States in the years

before and after World War II

Historically, when has the Federal government been

most likely to run budget deficits? What has been the

recent experience?

Define trade deficit and trade surplus In recent years,

has the U.s economy had trade deficits or trade

surpluses? What was the U.s experience from 1900

to 1970?

6 List the principal professional activities of macroecon­

omists What role does macroeconomic research play

in each of these activities?

7 What steps are involved in developing and testing an

economic theory or model? What are the criteria for a useful theory or model?

8 Might two economists agree about the effects of a partic­

ular economic policy but disagree about the desirability

of implementing the policy? Explain your answer

9 Compare the classical and Keynesian views on the speed

of wage and price adjustment What are the important consequences of the differences in their views?

What was stagflation, and when did it occur? How did

it change economists' views about macroeconomics?

N U M E R I C A L P RO B L E M S

Questions marked with a brown circle are available in

MyEconLab at www.myeconlab c om

Here are some macroeconomic data for the country of

Oz for the years 2005 and 2006

As the data suggest, Oz produces only potatoes, and its

monetary tmit is the shekel Calculate each of the following

macroeconomic variables for Oz, being sure to give units

a Average labor productivity in 2005 and 2006

b The growth rate of average labor productivity

between 2005 and 2006

c The unemployment rate in 2005 and 2006

d The inflation rate between 2005 and 2006

A N A LY T I C A L P RO B L E M S

Questions marked with a brown circle are available in

MyEconLab at w w w.m y econ l ab.com

Can average labor productivity fall even though total

output is rising? Can the unemployment rate rise even

though total output is rising?

Prices were much higher in the United States in 2006

than in 1890 Does this fact mean that people were

eco-nomically better off in 1890? Why or why not?

3 State a theory for why people vote Republican or

Democratic that potentially could satisfy the criteria for

a useful theory given in the text How would you go

about testing your theory?

Which of the following statements are positive in

nature and which are normative?

a A tax cut will raise interest rates

efit poor and middle-class workers

Chapter Summ ary 2 1

2 In a recent issue of the Survey of Current Business, find

the data section entitled "Selected NIPA Tables." In Table 1.1.5, "Gross Domestic Product," find data on gross domestic product (a measure of total output), exports, and imports In Table 3.2, "Federal Govern­ ment Current Receipts and Expenditures,"find data on the government's total receipts (taxes) and expendi­ tures These tables from the Survey of Current Business

can be accessed from the home page of the Bureau of Economic Analysis at www.bea.gov

a Calculate the ratio of exports to GOP, the ratio of

imports to GOP, and the ratio of the trade imbalance

to GOP in the latest reported quarter Compare the answers with the values reported for the previous two complete years

b Calculate the ratio of Federal government receipts to

GOP, the ratio of Federal government expenditures

to GOP, and the ratio of the budget deficit to GOP, for the most recent quarter and for the previous two complete years

c Payroll taxes are too high

d A cut in the payroll tax would improve the Presi­

dent's popularity ratings

e Payroll taxes should not be cut unless capital gains

taxes are cut also

5 In 2002, President George W Bush imposed tariffs on

certain types of imported steel He argued that for­ eign steel producers were dumping their steel on the U.s market at low prices The foreign steel producers were able to sell steel cheaply because they received subsidies from their governments The Bush adminis­ tration argued that the influx of steel was disrupting the U.s economy, harming the domestic steel indus­ try, and causing unemployment among U.S steel workers What might a classical economist say in response to these claims? Would a Keynesian econo­ mist be more or less sympathetic to the imposition of tariffs? Why?

22 Chapter 1 Introduction to Macroeconomics

WO R K I N G W I T H M A C RO E C O N O M I C DATA

For data to use in these exercises, go to the Federal Reserve Bank

of St Louis FRED database at research.stlouisfed.org/ fred

1 a Calculate the total percentage growth in average labor

productivity in the U.s economy for the 1950s, 1960s,

1970s, 1980s, and 1990s Define average labor produc­

tivity for any year as real gross domestic product in

the last quarter of the year divided by civilian

employment in the last month of the year In which

decades did average labor productivity grow the most

quickly overall? The most slowly? Express the growth

rates for each decade in annualized terms by using

the formula

(1 + g)'0 = 1 + G

where g is the annual growth rate, expressed as a

decimal (for example, 0.05 for 5%), and G is the

growth rate for the decade (the change in productiv­

ity during the decade divided by the initial produc­

tivity level) For each of the five decades, use your

calculated values for G and the formula above to

solve for g

b Calculate annual labor productivity growth rates for

each year since 2000 for which data are available How do the recent growth ra tes compare with those

of the five previous decades?

2 Graph the behavior of the civilian unemployment rate

from 1961 until the present using monthly data Can you see the periods of recession tha t occurred in 1969-1970, 1973-1975, 1980, 1981-1982, and 1990-1991?

In terms of the unemployment rate, how does the 2001 recession compare in severity with those earlier down­ turns? How does the behavior of the unemployment rate over the 1990s compare to its behavior in the 1960s, 1970s, and 1980s?

3 Using data on the consumer price index (CPI) for all

urban consumers, calculate and graph the annual U.s inflation rate (the percentage change in the price index, December to December) for each year since 1948 In which periods within the postwar era did the United States experience the most severe inflation problems?

In which periods has inflation been the most stable (that is, roughly constant from one year to the next)?

to obtain comprehensive measures of national output) and the team of Arthur Burns and Wesley Mitchell (who performed detailed measurements of the stages of the business cycle) showed that careful economic measurement is not only possible but also necessary for any serious understanding of the economy Their work, and the efforts of many other researchers, transformed economics from a field in which scholars relied on informal observations and broad generalizations to one in which numbers and statistical analysis play an essential role

In this chapter we present some of the conceptual and practical issues involved

in measuring the macroeconomy We focus on the national income accounts, a framework for measuring economic activity that is widely used by economic researchers and analysts Learning about the national income accounts will famil­iarize you with some useful economic data In addition, because the national income accounts are set up in a logical way that mirrors the structure of the econ­omy, working through these accounts is an important first step toward under­standing how the macroeconomy works When you finish this chapter, you will have a clearer understanding of the relationships that exist among key macroeco­nomic variables and among the different sectors of the economy

The national income accounts are an accounting framework used in measuring current economic activity Almost all countries have some form of official national income accounts (For background information on the U.s national income

23

24 Chapter 2 The Measurement and Structure of the National Economy

accounts, see the box "In Touch with the Macroeconomy: The National Income and Product Accounts," p 25)

The national income accolUlts are based on the idea that the amount of eco­nomic activity that occurs during a period of time can be measured in terms of

1 the amount of output produced, excluding output used up in intermediate

stages of production (the product approach);

2 the incomes received by the producers of output (the income approach); and

3 the amount of spending by the ultimate purchasers of output (the expenditure

approach)

Each approach gives a different perspective on the economy However, the fundamental principle underlying national income accounting is that, except for problems such as incomplete or misreported data, all three approaches give identical measurements of the amount of current economic activity

We can illustrate why these three approaches are equivalent by an example Imagine an economy with only two businesses, called OrangeInc and JuiceInc OrangeInc owns and operates orange groves It sells some of its oranges directly to the public It sells the rest of its oranges to JuiceInc, which produces and sells orange juice The following table shows the transactions of each business during a year

Orange Inc Transactions

Wages paid to Orange Inc employees Taxes paid to government

Revenue received from sale of oranges

Oranges sold to public

Oranges sold to Juicelnc

Juicelnc Transactions

Wages paid to Juicelnc employees

Taxes paid to government

O r an g es purchased from Orangelnc

Revenue received from sale of orange juice

$1 5,000

5,000 35,000

1 0,000 25,000

$ 1 0,000 2,000 25,000 40,000

OrangeInc pays $15,000 per year in wages to workers to pick oranges, and it sells these oranges for $35,000 ($10,000 worth of oranges to households and $25,000 worth

of oranges to JuiceInc) Thus OrangeInc's profit before taxes is $35,000 - $15,000 =

$20,000 Because OrangeInc pays taxes of $5000, its after-tax profit is $15,000

JuiceInc buys $25,000 of oranges from OrangeInc and pays wages of $10,000 to workers to process the oranges into orange juice It sells the orange juice for

$40,000, so its profit before taxes is $5000 ($40,000 - $25,000 - $10,000) After paying taxes of $2000, its after-tax profit is $3000

What is the total value, measured in dollars, of the economic activity generated

by these two businesses? The product approach, income approach, and expendi­ture approach are three different ways of arriving at the answer to this question; all yield the same answer

1 The product approach measures economic activity by adding the market values of goods and services produced, excluding any goods and services used up

in intermediate stages of production This approach makes use of the value-added concept The value added of any producer is the value of its output minus the value